Cost of Equity

Long term loans defined as falling due after one years time, are not part of shareholders funds and therefore are not owned by shareholders, they are owned by the issuer or loan provider. The owners of the loan are rewarded with interest payments. These sources of capital are not without cost. Managers and shareholders must evaluate and decide how to structure the capital. In determining the capital structure of a company, management must decide upon a level of gearing. Gearing, also known as leveraging, is a measure of the level of debt to that of equity. The ratio is given in terms of debt, its value, over that of equity. Rolls Royce had a gearing ratio of 67.67 percent in 2000. In comparison to the previous year, the company experienced a 21.7 percent reduction, in gearing ratios, down from 89.47. This shows that the company has decreased it level of debt in proportion to the amount of its equity.

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There are two major ways by which to view the capital structure decision. Analysts Modigliani and Miller showed a number of the effects of increased gearing. The advantages of debt are that it is a less costly form of capital and it brings tax relief. The disadvantages to gearing are that as the level increases so does financial risk thereby increasing the cost of equity. However, in the M&M analysis the end result is a net advantage, where gearing increases and the after tax WACC declines. This analysis suggest that a company should gear up as mush as possible, and those with higher levels of debt to equity will have a greater increase in shareholders wealth.

In opposition to this is the more traditional view, which states there are advantages to gearing but as the gearing level increases a reverse relationship arises and the market value declines. In the real world we see that companies do not tend to follow the M&M theory, taking on extreme levels of debt, and therefore can conclude that there may be factors missing from this analysis. These missing, real world qualities could include bankruptcy costs, agency costs, debt capacity, and tax exhaustion.

Rolls Royce is a leveraged company. The gearing ratio of its total debt to common equity is 67.67%. The company’s total debt figure includes both long term and short term borrowings. The company’s equity is comprised totally of ordinary shares, they do not issue preference shares. In order to estimate the cost of financing ordinary share capital it is necessary to know the dividend policy that the company has adopted.

The most common, and the one in which Rolls Royce uses, is known as the “dividend growth model” or “dividend growth policy”. This model assumes that dividend payments will rise at a constant annual rate in perpetuity. This growth rate can be found by taking the average growth of past payments in relation to the number of time periods, assuming that this rate will continue. Rolls Royce has continued to add value to its shareholders wealth over the past decade. More recently, the five-year historical growth rate has been approximately 10%, with total dividends paid growing from 126 million in 2000. Turnover and operating profits have also both grown at a rate of 10% in the last five years. For 2001 underlying profits are expected to be flat but are expected to resume growth in 2002.

The company has chosen to follow a stable dividend policy increasing payments by an average of 10% per year. Historically it has been in a strong position, with strong sales and a large order book, to offer its shareholders larger payments. It need not worry about being left with insufficient finance for future undertakings. Any reduction in dividends could lead to the “clientele effect” in which shareholders may view a reduction as a sign of financial instability and therefore look else where for safer and more lucrative investments.

Cost of Equity

By understanding the dividend policy that the company has adopted, and in calculating the average growth rate, we can then go on to estimate the cost of financing ordinary shares. This “cost” is also the return on equity capital form the investors point of view. It is the rate of return that they expect to receive from investing in the company’s shares. This can be identified by the capital asset pricing model (CAPM).

This is the expected return on the investment in ordinary shares, that is equal to the risk free return plus a risk premium, determined by the market price of systematic risk and the level of risk of Rolls Royce shares. For the purpose of this report we take management’s viewpoint in which this cost represents the minimum return that must be sought when investing shareholders funds. It can then be viewed as the opportunity cost of capital. Either using the CAPM, or in this case using the dividend valuation model can calculate it.

This cost of equity is calculated as the dividend yield for the next year plus the percentage of annual dividend growth. Next years dividend yield is the last dividend that was paid multiplied by one plus the growth rate, divided by the current market value of the shares. Rolls Royce who paid a dividend of 8.00p per ordinary share paid a total of �126 million in dividends for 2000. The company has adopted a growth model with a 10% growth factor and whose shares are traded on the market at 184.25p for a total of �2932 million. Thus, it has an estimated cost of equity of 14.72% per annum.

The method used to estimate the cost of issuing preference shares is identical to that of irredeemable loans. However, Rolls Royce does has not issued preference shares and therefore this does not factor into the cost of equity. Cost of Debt Debt capital can be defined as a loan that is made to a company that will be repaid at a future date. This differs from share capital in two major ways. The issuers of debt do not own part of the company, and the payments they receive in the form of interest are a fixed annual rate whereas dividend are not contractually fixed. These payments are placed above equity in terms of payment. With a fixed rate of return, interest payments, a fixed time of payment, and preferential treatment, debt serves as a much less risky form of capital for a company.